Behavioral Finance And Indexing

June 12, 2008



John Prestbo, editor and executive director, Dow Jones Indexes

JoI: What does behavioral finance tell us about investing and indexing?

John Prestbo, Dow Jones Indexes (Prestbo): It tells us that irrationality and emotionality stand in the way of most people being able to manage their investment portfolios prudently. These people can turn this management over to professionals, except that those professionals are people too, and therefore subject to behavioral quirks. Or, they can place their portfolios in diversified indexed vehicles and reap the benefits of market returns at lower cost.

JoI: What are the biggest mistakes investors make from a behavioral standpoint?

Prestbo: First, they follow the crowd—emphasis on follow—which means they buy high and sell low. Second, they fear loss more than they desire gain, which causes many investors to hang on to both winners and losers too long. Third, they weigh too heavily the implications drawn from small data samples or the recommendation of a single analyst.

JoI: Is behavioral finance being used to justify poor investment decisions and a lack of education?

Prestbo: I think it's more explanation than justification. People in all walks of life must take responsibility for their investments, just as they do their tax returns. We're making considerable progress in this regard—when I started out with The Wall Street Journal 44 years ago, most ''ordinary'' folks were totally mystified and intimidated by investing. Far fewer are bewildered today, though there's still plenty of room for improvement.

JoI: If indexing is proven to provide the best odds for long-term success, why don't more investors index?

Prestbo: Obviously the superiority of indexing hasn't been ''proven'' to everyone's satisfaction. Ironically, one of the side effects of more and more people becoming educated about investing is that some of them will eschew indexing and take an active role. And certain people like to try beating the odds. The day that all investors index will never arrive.

JoI: Can active managers use behavioral insights to outperform the market?

Prestbo: One would think so, at least in theory, but so far behavioral finance seems to be an academic phenomenon rather than a real-world one. Perhaps a way of putting behavioral finance to work would be an active manager having a robust strategy and the discipline to stick with it through thick and thin.

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